Internal audit in banks and the supervisor's relationship with auditors (Basel Committee publcations
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CIRCULAR BM_- 919 October 17, 2001 To: All Licensed Banks in Oman Sub: Internal Audit Function in Banks 1. As banks are already aware, the Basel Committee on Banking Supervision has recently issued a paper on Internal Audit in Banks and the Supervisor’s Relationship with Auditors, with the objective of enhancing the internal audit function and harmonising and improving internal audit standards internationally. The paper contains 20 Principles, which are intended for general application, even though they could be applied within a specific supervisory framework. The Central Bank of Oman also subscribes to the view that strong internal control including audit function is an essential component of sound corporate governance practices in banks. 2. Accordingly, a copy of the paper is enclosed for necessary action. Banks are directed to review their existing internal audit function vis-à-vis the Principles, particularly Principles 1-12, 16, 19 and 20 and chart a definite timeframe for addressing gaps, in the context of the size, complexity of operations, etc. Banks are also directed to carry out a review and prepare an action plan for improving the existing internal audit function, duly approved by the Board of Directors, as soon as possible and in any case not later than December 31, 2001. A copy of the review together with the action plan should be forwarded to the Central Bank of Oman. 1 3. Banks are required ...
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_ CIRCULAR BM - 919
October 17, 2001 To: All Licensed Banks in Oman Sub: Internal Audit Function in Banks 1. As banks are already aware, the Basel Committee on Banking Supervision has recently issued a paper onInternal Audit in Banks and the Supervisor s Relationship with Auditors, with the objective of enhancing the internal audit function and harmonising and improving internal audit standards internationally. The paper contains20 Principles, which are intended for general application, even though they could be applied within a specific supervisory framework. The Central Bank of Oman also subscribes to the view that strong internal control including audit function is an essential component of sound corporate governance practices in banks.
2. Accordingly, a copy of the paper is enclosed for necessary action. Banks are directed to review their existing internal audit function vis-à-vis the Principles, particularly Principles 1-12, 16, 19 and 20 and chart a definite timeframe for addressing gaps, in the context of the size, complexity of operations, etc. Banks are also directed to carry out a review and prepare an action plan for improving the existing internal audit function, duly approved by the Board of Directors, as soon as possible and in any case not later than December 31, 2001. A copy of the review together with the action plan should be forwarded to the Central Bank of Oman.
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3. Banks are required to note that any change in the incumbency of the Head, internal audit and the circumstances for the change should immediately be brought to our notice. The Central Bank of Oman is also interested in one-to-one meeting with the head of the internal audit department when he has been relieved of duties.
Best Regards, Hamood Sangour Al Zadjali The Executive President
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August 2001
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Table of Contents
Introduction ............................................................................................................................ 1 Definition of internal audit....................................................................................................... 2 Objectives and tasks of the internal audit function.................................................................. 2 Principles of internal audit ...................................................................................................... 4 Permanent Function Continuity .................................................................................. 4 Independent function..................................................................................................... 4 Audit charter ................................................................................................................. 5 Impartiality .................................................................................................................... 6 Professional competence .............................................................................................. 6 Scope of activity............................................................................................................ 7 The bank’s internal capital assessment procedure ........................................................ 8 Functioning of internal audit ................................................................................................... 9 Working methods and types of audit ............................................................................. 9 Risk focus and audit plan .............................................................................................. 9 Procedures ................................................................................................................. 10 Management of the internal audit department ............................................................. 10 The relationship of the supervisory authority with the internal audit department and with the external auditor .................................................................................................................... 11 The relationship of the supervisory authority and the internal audit department .......... 11 The relationship of the internal auditors and the external auditors............................... 12 The relationship between the supervisory authority and the external auditor............... 13 Cooperation among the supervisory authority, the external auditors and the internal auditors ....................................................................................................................... 15 Audit Committee .................................................................................................................. 15 Definition..................................................................................................................... 15 Composition, powers and functioning.......................................................................... 16 Relevant aspects ........................................................................................................ 16 Outsourcing of internal audit ................................................................................................ 17 Definition..................................................................................................................... 17 Outsourcing of the internal audit ................................................................................. 17 Outsourcing of internal audit activities in small banks.................................................. 18
Task Force on Accounting Issues of the Basel Committee on Banking Supervision
Chairman: Prof Arnold Schilder, De Nederlandsche Bank, Amsterdam Commission Bancaire et Financière, Brussels Mr Marc Pickeur Office of the Superintendent of Financial Institutions Canada, Ms Donna Bovolaneas Toronto Commission Bancaire, Paris Mr Philippe Bui Deutsche Bundesbank, Frankfurt am Main Mr Karl-Heinz Hillen Bundesaufsichtsamt für das Kreditwesen, Bonn Mr Ludger Hanenberg Banca d’Italia, Rome Dr Carlo Calandrini Bank of Japan, Tokyo Mr Hiroshi Ota Financial Services Agency, Tokyo Mr Nobuhiro Hayashi Commission de Surveillance du Secteur Financier, Mr Guy Haas Luxembourg De Nederlandsche Bank, Amsterdam Mr Michael Dobbyn Mr André van Dorssen Banco d'España, Madrid Mr Anselmo Diaz Finansinspektionen, Stockholm Mr Hans Hultin Eidgenössische Bankenkommission, Bern Mr Stephan Rieder Bank of England, London Mr Ian Michael Financial Services Authority, London Ms Deborah Chesworth Board of Governors of the Federal Reserve System, Mr Gerald Edwards Washington, DC Federal Reserve Bank of New York Mr James Beit Office of the Comptroller of the Currency, Washington, DC Mr Zane Blackburn Federal Deposit Insurance Corporation, Washington, DC Mr Robert Storch Observers European Commission, Brussels Oesterreichische Nationalbank, Vienna Saudi Arabian Monetary Agency, Riyadh Monetary Authority of Singapore, Singapore Secretariat Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements
Mr Vittorio Pinelli Mr Martin Hammer Mr Tariq Javed Mr Timothy Ng
Mr Bengt A Mettinger
Introduction 1. As part of its ongoing efforts to address bank supervisory issues and enhance supervision through guidance that encourages sound practices, the Basel Committee on Banking Supervision (The Committee) is issuing this paper on internal audit in banking organisations and the relationship of the supervisory authorities with internal and external auditors. Adequate internal controls within banking organisations must be supplemented by an effective internal audit function that independently evaluates the control systems within the organisation. External auditors, on the other hand, can provide an important feedback on the effectiveness of this process. Banking supervisors must be satisfied that effective policies and practices are followed and that management takes appropriate corrective action in response to internal control weaknesses identified by internal and external auditors. Finally, co-operation between the supervisor, the internal auditor and the external auditor optimises supervision. 2. The principles set out in this paper are intended to be of general application, even though they will have to be applied within a specific supervisory framework. There are significant differences across countries as regards the use of on-site and off-site supervisory techniques. Also the degree to which external auditors are used in the supervisory function varies widely. While the exact approach chosen by supervisors in individual countries will depend on these types of factors, all members of the Committee agree on the principles set out in this paper. 3. This paper refers to a management structure composed of a board of directors and senior management. The Committee is aware that there are significant differences in legislative and regulatory frameworks across countries as regards the functions of the board of directors and senior management. In some countries, the board has the main, if not exclusive, function of supervising the executive body (senior management, general management) so as to ensure that the latter fulfils its tasks. For this reason, in some cases, it is known as a supervisory board. This means that the board has no executive functions. In other countries, by contrast, the board has a broader competence in that it lays down the general framework for the management of the bank. Owing to these differences, the notions of the board of directors and senior management are used in this paper not to identify legal constructs but rather to label two decision-making functions within a bank. The principles set out in this paper should be applied in accordance with the national corporate governance structure of each country. It might also be useful to consult the Committee’s paper “Enhancing Corporate Governance for Banking Organisations published in September 1999. 4. This document serves as basic guidance for supervisors and it sets out banking supervisors’ views on internal audit in banking organisations and the relationship of the supervisory authorities with internal and external auditors. The Committee supports efforts to harmonise and improve internal audit standards internationally. The Committee promotes due consideration of prudential issues in the development of domestic and international internal audit standards. 5. An internal audit function within a bank that is organised along the principles set forth in this paper facilitates the work of bank supervisors. Strong internal control, including an internal audit function, and an independent external audit are part of sound corporate governance which in turn can contribute to an efficient and collaborative working relationship between bank management and bank supervisors. An effective internal audit function is a valuable source of information for bank management, as well as bank supervisors, about the quality of the internal control system. 6. The principles set forth in this paper apply to banks, including those within a banking group, and to holding companies whose subsidiaries are predominantly banks. 1
7. This document elaborates on the policy guidance issued by the Committee in 1998 entitled "for Internal Control Systems of Banking OrganisationsFramework ", particularly the principles about the internal audit function. This 1998 framework provides significant international supervisory guidance on the evaluation of bank internal controls based on an advanced, modern internal control framework.
Definition of internal audit 8. In June 1999, the Board of Directors of the Institute of Internal Auditors approved the following definition of internal audit: “Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. 9. The need for objectivity and impartiality, especially important for the internal audit department within the banking industry, does not necessarily exclude the possibility that the internal audit department is involved in advising or consulting. Advising senior management on the development of internal controls is often a cost-effective way of ensuring that management makes an informed decision when controls need to be introduced. However, other forms of advising or consulting should be ancillary to the basic function of internal audit, which is an independent appraisal function established within the bank to examine and evaluate its internal control systems, including controls over financial reporting. Internal auditors should not be precluded from analysing and criticising the internal controls that have been put in place by, or at the direction of, senior management even though the auditor provided advice to senior management about internal controls that should be instituted. 10. Some banks have chosen to introduce control self-assessments. These can be described as a formal and documented process whereby management and/or a staff team analyse their activity or function and evaluate the efficiency and effectiveness of the related internal control procedures. These self-assessments may be a useful technique for evaluating the efficiency and effectiveness of internal control without being a substitute for internal audit.
Objectives and tasks of the internal audit function Principle 1 The bank s board of directors has the ultimate responsibility for ensuring that senior ’ l management establishes and maintains an adequate and effective system of intern’a controls, a measurement system for assessing the various risks of the bank s ’ activities, a system for relating risks to the bank s capital level, and appropriate methods for monitoring compliance with laws, regulations, and supervisory and internal policies. At least once a year, the board of directors should review the internal control system and the capital assessment procedure. 11. The board of directors should regularly verify whether the bank has established an adequate system of internal controls to ensure a well-ordered and prudent conduct of business (with reference to clearly defined objectives). The board should also regularly verify 2
whether the bank has developed a system for relating risks to the bank’s capital level. Finally, the board should ensure that the bank has processes for identifying and adequately controlling the risks incurred in pursuing its business objectives; for testing the integrity, reliability and timeliness of financial information and management information; and for monitoring compliance with laws and regulations, supervisory policies, and internal plans, policies, and procedures.
Principle 2 ’ The bank s senior management is responsible for developing processes that identify, measure, monitor and control risks incurred by the bank. At least once a year, senior management should report to the board of directors on the scope and performance of the internal control system and of the capital assessment procedure. 12. Senior management should maintain an organisational structure that clearly assigns responsibility, authority and reporting relationships and ensures that delegated responsibilities are effectively carried out. Senior management is also responsible for developing risk management processes that identify, measure, monitor and control risks. Finally, senior management sets appropriate internal control policies and monitors the adequacy and effectiveness of the internal control system.
Principle 3 Internal audit is part of the ongoing monitoring of the bank's system of internal controls and of its internal capital assessment procedure, because internal audit provi’des an independent assessment of the adequacy of, and compliance with, the bank s established policies and procedures. As such, the internal audit function assists senior management and the board of directors in the efficient and effective discharge of their responsibilities as described above. 13. From a general point of view, the scope of internal audit includes: • the examination and evaluation of the adequacy and effectiveness of the internal control systems; • review of the application and effectiveness of risk management procedures and the risk assessment methodologies; • review of thethe management and financial information systems, including the electronic information system and electronic banking services; • review of the accuracy and reliability of the accounting records and financial the reports; • the review of the means of safeguarding assets; • the review of the bank’s system of assessing its capital in relation to its estimate of risk; • appraisal of the economy and efficiency of the operations; the • the testing of both transactions and the functioning of specific internal control procedures; 3
